The Fed Has More Cutting to Do

November 07, 2001

By Rich Miller Federal Reserve Chairman Alan Greenspan and his fellow central bankers look to be pulling out all the stops in their efforts to get the economy moving again. They've cut short-term interest rates 10 times this year, by a whopping 4 percentage points. The latest reduction, a half-point cut on Nov. 6, left the overnight interbank federal funds rate at a mere 2%, its lowest level in four decades. The largely symbolic discount rate, the rate the Fed charges on emergency loans to private banks, is even lower, at 1.

Appearances, though, can be deceiving. Sure, short-term rates have fallen sharply this year. But real inflation-adjusted rates still remain too high, at least when they are calculated using Greenspan's favorite inflation gauge, the personal consumption expenditure (PCE) deflator. The Fed chairman favors that stat because it seeks to measure price increases on goods and services that people actually use and buy, as opposed to the more widely used consumer price index (CPI), which doesn't account for changing consumer preferences. By that measure, real short-term rates stand at 1%.

NOT THERE YET. While that sounds awfully low, it's still not low enough. In past downturns, inflation-adjusted short-term rates have usually had to fall to zero, or even turn negative before the economy has been able to recover. What's more, long-term rates, which have far more of an impact on the economy than the Fed funds rate, have only just recently started to turn down. All that suggests that the Fed needs to keep cutting the nominal funds rates -- to 1% or even lower -- to rev up the recession-wracked economy.

For much of this year, Greenspan & Co. have been frustrated by their failure to bring long-term rates down, despite repeated cuts in short-term rates. Long-term rates remained elevated thanks to widespread expectations of a second-half economic rebound next year and fears that deteriorating government finances would lead to a stepped-up supply of Treasury securities.

To help get those stubborn long-term rates down, Greenspan got a hand from a former Fed colleague, Treasury Under Secretary Peter R. Fisher. In a move that stunned financial markets and sent long-term rates skidding lower, Fisher announced on Oct. 31 that Treasury was scrapping sales of its 30-year bond. Although Treasury denied it was trying to drive rates down, the action had exactly that effect as traders and investors scrambled to snap up 30-year bonds.

Now Greenspan seems to be looking to Europe for further help in bringing down long-term U.S. interest rates. In what was widely seen as an attempt to nudge the European Central Bank into cutting rates more aggressively, the Fed cited weaker growth overseas as a key reason for its Nov. 6 rate-cut decision.

HOW LOW? European rates are important because 30% to 40% of U.S. corporate bonds are sold abroad, primarily to European investors. To entice those buyers, U.S. companies need to keep the yields on their bonds competitive. "European rates put a floor under U.S. rates," says Louis B. Crandall, chief economist at consultants R.H. Wrightson & Associates in New York.

Still, the combination isn't enough. Fed policy makers, citing the troubled outlook on Nov. 6, all but admitted they may need to cut rates further. But it's not clear how quickly they're prepared to move. Only one of the Fed's 12 regional banks asked for a half-point cut in the discount rate on Nov. 6, suggesting that at least some policymakers were hesitant about cutting rates so sharply, because they felt the Fed has already done enough to spur the economy.

So how low should the Fed go? After stripping out volatile food and energy costs, the core PCE deflator is running at an annual rate of 1%. To bring on that much anticipated V-shaped recovery, the Fed needs to bring the funds rate down at least that low. And the sooner it does so, the better. Miller covers the Federal Reserve from Washington.